Sunday, August 17, 2008

How fuel subsidies drag down a nation

Robert Frank, an economist writing for the NY Times, highlights the fact that government fuel subsidies encourage drivers to be more wasteful, and that every bit of waste costs the government giving the subsidy.

A more appropriate venue to alleviate hardship for the poor would be to give them a tax cut (or a rebate, as is done in the US with the Earned Income Tax Credit).

Malaysia has had to end or sharply curtail (can't remember which) its fuel subsidies. Frank also points out that the US is effectively engaging in a subsidy, as gasoline prices here understate the full costs (including environmental costs, for example) of gasoline use.

Consider how this difference might affect a trucker’s decision about whether to accept a hauling job. A rational trucker will apply the basic cost-benefit test, which says that something is worth doing if, and only if, its benefit is at least as great as its cost. Suppose the job in question requires 1,000 gallons of fuel, available at the subsidized price of $2 a gallon, for a total fuel outlay of $2,000. If the cost of the trucker’s time and equipment are, say, $1,000 for the trip, his narrow interests dictate accepting the job if the shipper is willing to pay at least $3,000. Suppose the shipper is willing to pay that amount but not more.

The problem is that if the trucker accepts the job at that price, the country as a whole will be worse off by more than $2,000. Although the $3,000 fee would cover his own costs, the government would end up paying $2,000 in additional subsidies for the 1,000 gallons consumed. On top of that, the trip would generate additional pollution and congestion costs. So the fact that the subsidy encouraged him to accept the job means that its net effect is equivalent to throwing more than $2,000 onto a bonfire.

Waste is always bad. Anyone who doubts it need only remember that when the economic pie grows, it is always possible for everyone to have a larger slice than before. Using fuel for activities whose costs exceed their benefits makes the economic pie smaller.

Subsidy proponents cite the firestorm of political protest that would erupt if fuel were to sell at the international market price. That fuel subsidies are wasteful, however, implies that there must be less costly ways to keep the peace.

Consider again our trucker who accepted a job that barely covered the cost of his time, equipment and subsidized fuel. Instead of paying $2,000 to subsidize his fuel, the government could give him a tax cut of, say, $1,000, and use the remaining $1,000 to help pay for public services. Because the trucker’s earnings from the hauling job were only enough to cover his costs at the subsidized fuel price, he would be $1,000 better off with the tax cut alone than with the fuel subsidy. The additional support for public services would augment this benefit. In short, a tax cut is always a better way to keep political protest at bay because, unlike a fuel subsidy, it does not encourage shipments whose costs exceed their benefits.

IF a United States president urged developing economies to eliminate fuel subsidies because they result in higher energy prices for Americans, the conversation would probably end very quickly. But this conversation might be reframed.

A good place to start would be to heed the same advice we’d like others to follow. Emerging economies are not the only ones in which prices at the pump substantially understate the true social cost of fuel. For instance, although the United States doesn’t have direct fuel subsidies, existing fuel taxes significantly understate the pollution and congestion costs associated with additional fuel use. Adopting some variant of a tax on carbon, as both leading presidential candidates have proposed, would help eliminate this discrepancy.

That would set the stage for our next president to explain to other leaders why eliminating fuel subsidies would make the overall economic pie larger. Because the resulting efficiency gains can be redistributed so that everyone gets a bigger slice than before, the idea should be fairly easy to sell.

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